Insurance Credit Rating Methodology

June 2012

Morningstar 2012. All Rights Reserved. Redistribution is prohibited without written permission. Morningstars Credit Ratings & Research is
produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized
Statistical Rating Organization (NRSRO).

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Morningstar Insurance Credit Rating Methodology
Credit Score
Four quantitative pillars drive the insurance credit rating methodology:
1. Insurance Business Risk Score: This metric encompasses various measures of an insurer's
business risk, as well as Morningstar's proprietary Economic Moat and Uncertainty Ratings.
Weighting: 45%
2. Insurance Debt Cushion Score: This is an evaluation of an insurer's ability to cover debt and
interest obligations with its balance sheet surplus and future profitability. Weighting: 25%
3. Insurance Financial Risk Score: This is a ranking based on an insurer's reserves leverage, debtto-capital levels, and sensitivity to potential losses in its investment portfolio relative to other
insurers. Weighting: 20%
4. Distance to Default: This is a quantitative model that rank-orders firms based on their likelihood of
financial distress using market-based inputs. Weighting: 10%.
We have set the weightings for each of the pillars such that our assessment of an insurer's credit risk is
equally weighted between its business (Business Risk) and financial risk (Debt Cushion and Financial Risk).
Because the Financial Risk score tends to be much more variable across insurers, we assign it a lower
weighting than the Debt Cushion score. The weighted average of an insurer's score on all four pillars
determines the model-recommended final credit score.
Underlying this rating is a fundamentally focused methodology, a robust, standardized set of procedures, and
core financial risk and valuation tools used by Morningstar's securities analysts. Based on other qualitative
and quantitative factors (e.g. positive/negative trends in various metrics, upcoming corporate actions, etc.),
analysts and the credit rating committee will also discuss, and potentially adjust, the recommended score
appropriately. All of our credit ratings are reviewed and approved by Morningstar's credit rating committee.
I. Insurance Business Risk Score
The Business Risk Score for insurers is similar to the scoring system used for nonfinancial companies.
However, it also takes into consideration four insurance-specific considerations: regulatory environment,
underwriting profitability, the volatility of underwriting profitability, and overall level of underwriting risk.
Two separate component scores converge to form our final Business Risk Score: country risk and company
risk. Once we assign these two component scores, we weight them as follows to determine the overall
Business Risk score for each insurer:
Country risk: 10% weighting
Company risk: 90% weighting
Country Risk
No matter how solid an insurer's balance sheet, if it operates in an unstable political or economic
environment, it deserves a lower credit rating than a similar firm operating under more benign conditions. We
capture our assessment of this consideration by assigning an insurer a score between 1 and 25, with 25
representing the most favorable, or most stable, macro environment rating for this measure.
Morningstar Insurance Credit Rating Methodology

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Company Risk
Size (1-10 points)
We believe that size is relevant in assessing the credit quality of insurers. Large insurers generally have better
access to capital markets, and they have more parties with stakes in their survival. We include separate
accounts in the size calculation. While these assets are not held for the company's benefit, we believe they
factor into the second consideration mentioned above. We rank each insurer on the basis of its asset size on
the following scale:
1 point: Less than $780 million
2 points: Between $780 million and $1.5 billion
3 points: Between $1.5 billion and $3.1 billion
4 points: Between $3.1 billion and $6.2 billion
5 points: Between $6.2 billion and $12.5 billion
6 points: Between $12.5 billion and $25 billion
7 points: Between $25 billion and $50 billion
8 points: Between $50 billion and $100 billion
9 points: Between $100 billion and $200 billion
10 points: Greater than $200 billion
The breakpoints were set using a sample of publicly traded insurers, and targeting a normal distribution.
Economic Moat (1-10 points)
An essential part of our company analysis is the Economic MoatTM Rating, which encapsulates our view of a
company's competitive advantage and ability to earn excess returns on capital.
1 point: No Moat
5 points: Narrow Moat
10 points: Wide Moat
Uncertainty Rating (1-10 points)
We assign a score based on a company's Equity Uncertainty Rating, as determined by our analysts.
1 point: Extreme
2.5 points: Very High
5 points: High
7.5 points: Medium
10 points: Low
Management Grade (1-5 points)
Our analysts assign each company we cover a management score of 1 to 5. The score captures our view of a
company's transparency, financial prudence, and management credibility. We place particular emphasis on
how conservative a management team is in managing its balance sheet, its policies with regards to share
buybacks and dividends, its tendency toward M&A activity, and other factors affecting bondholders. We also
consider whether the firm does what it says it is going to do with respect to the balance sheet: Has it
surprised bond holders (in a bad way) in the past? Is management willing to make hard choices (cut the
dividend, dilute equity, etc.) in order to maintain its financial health?

Morningstar Insurance Credit Rating Methodology

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1 point: Poor
2 points: Below Average
3 points: Average
4 points: Above Average
5 points: Excellent
Regulatory Environment (1-5 points)
Our analysts assess the regulatory environment surrounding each insurer. For example, insurers with
concentrated operations in states where the insurance commissioner is elected rather than appointed run a
higher risk of negative regulatory outcomes to appease public opinion. We also make a distinction between
personal and commercial lines, which stems from our belief that insurers operating in commercial lines run a
lower risk of adverse regulatory outcomes to appease public opinion. Finally, we view Bermuda-based
insurers favorably on this front, as the island's regulatory environment promotes financial strength relative to
our insurance coverage universe in general. The Bermuda market includes a significant wholesale
component, where regulation is driven less significantly by attempts to regulate rates, terms, and other
conditions that impact the ultimate policyholder.
1 point: Extreme exposure to negative regulatory outcomes
2 point: Heightened exposure to negative regulatory outcomes
3 points: Baseline
4 points: Low exposure to negative regulatory outcomes
5 points: Negligible exposure to negative regulatory outcomes
Underwriting Profitability (1-10 points)
To assess underwriting profitability, we measure an insurer's combined ratio. A ratio of 100% means the
insurer breaks even on underwriting. We use a modified combined ratio that includes fee income to make the
measure relevant to life insurers, which typically generate a substantial amount of fee income. We use a 7year average as the starting point for this score, as we believe this time period is sufficient to cover a cycle,
and smooth out the effects of outlier results. We then adjust the measure accordingly to capture our
expectations of future underwriting profitability.
We use the following scale to assess the insurer's underwriting profitability:
1 point: Greater than 130%
2 points: Between 120% and 130%
3 points: Between 110% and 120%
4 points: Between 105% and 110%
5 points: Between 100% and 105%
6 points: Between 95% and 100%
7 points: Between 90 and 95%
8 points: Between 80% and 90%
9 points: Between 70% and 80%
10 points: Less than 70%

Morningstar Insurance Credit Rating Methodology

Volatility of Underwriting Profitability (1-10 points)

We assess the historical range of an insurer's modified combined ratio to further gauge its underwriting
practices and potential magnitude of losses. An insurer's 7-year track record is used as the starting point for
this score. We then adjust the measure accordingly to capture our expectations of the future volatility of
underwriting profitability.
1 point: Greater than 36 percentage points
2 points: Between 32 and 36 percentage points
3 points: Between 28 and 32 percentage points
4 points: Between 24 and 28 percentage points
5 points: Between 20 and 24 percentage points
6 points: Between 16 and 20 percentage points
7 points: Between 12 and 16 percentage points
8 points: Between 8 and 12 percentage points
9 points: Between 4 and 8 percentage points
10 points: Less than 4 percentage points
Overall Level of Underwriting Risk (1-20 points)
We assess the overall level of an insurer's underwriting risk, applying baseline scores for each subindustry
(life, P&C, and reinsurance). Analysts and the credit rating committee may adjust away from these baseline
scores for any relevant, firm-specific considerations. In cases where a company operates in different lines,
the score is proportional to the amount of premiums collected in each line.
4 points: Reinsurance
10 points: P&C
17 points: Life
The Country Risk and Company Risk scores are weighted, respectively, and then added together, resulting in
a possible range of Business Risk Scores between 0 (best) and 1 (worst).
II. Insurance Debt Cushion Score
The Debt Cushion Score measures the insurer's ability to cover its debt load and future interest payments
with its balance sheet surplus and future profitability. It is derived in three steps:
1. Balance Sheet Surplus: This is calculated as follows, and uses data from the last historical year. We
assess whether to adjust for reinsurance recoverables on a company-by-company basis:
Investments + Cash - Reserves - Net Unearned Premiums / Premiums Receivable
2. Total Profitability Available for Debt Service: This is calculated as follows, and is taken from our 5year projections:
Premiums + Fee & Other Income - Operating Expenses + Investment Income Taxes

Morningstar Insurance Credit Rating Methodology

3. These two numbers are added together, and then divided by the debt balance plus projected
interest expense, to calculate the Debt Cushion Score.
The Debt Cushion can be interpreted as primarily a leverage ratio, but it has more robust features. It is
forward-looking, and not only takes into account both earnings power and leverage, but also allows its
individual components to be dissected and analyzed.

The higher the balance sheet leverage, the lower the score.
The lower the future profitability ("earnings power"), the lower the score.
The higher the debt level, the lower the score.
For insurers with volatile claims exposure, analysts typically include a high-loss year in future
projections, so the higher the claims volatility, the lower the score.

The rating score is expressed as 1 minus the inverse of the Debt Cushion ratio, with a range of scores
between 0 (best) and 1 (worst).
A sample Debt Cushion calculation is shown below:
Debt Cushion Score
Surplus Calculation
Investment Portfolio
Cash
Minus: Reserves
Minus: Net Unearned Premiums/Premiums Receivable
Balance Sheet Surplus
Plus: Interim Investment Gains (Losses)
Plus: Equity Capital Raised
Other Adjustments
Adjusted Balance Sheet Surplus

0.80

14,713.4
160.7
6,653.0
1,718.1
6,503.0

564.8
7,067.8

Profitability Calculation
Premiums
Plus: Fee & Other Income
Minus: Operating Expenses
Operating Profitability
Plus: Investment Income
Minus: Tax Expense
Profitability Available For Debt Service
Debt Cushion Calculation
Adjusted Balance Sheet Surplus
Total Profitability Available for Debt Service
Total Projected Surplus
Debt Balance
Interest Expense
Total Debt Service

7,067.8
6,978.1
14,045.9
2,177.2
617.2
2,794.4

Debt Cushion

5.03

Components
Balance Sheet Surplus
Total Profitability
Operating Profitability
Investment Income

2.53
2.50
1.70
0.80

Morningstar Insurance Credit Rating Methodology

>>> raw score

Dec-10
14,543.4
5.4
13,453.6
1,095.2

Dec-11
15,297.6
5.4
14,000.1
1,302.9

Dec-12
16,653.7
5.4
14,921.7
1,737.4

Dec-13
17,883.1
5.4
16,828.4
1,060.1

Dec-14
19,025.2
5.4
17,314.7
1,715.9

505.7
493.3

530.3
576.3

557.9
729.9

735.3
561.0

938.5
840.4

1,107.7

1,256.8

1,565.3

1,234.3

1,814.0

The hypothetical insurance company shown above has an average overall Debt Cushion score (5.03). It
derives the majority of its profitability through operating activities (1.7), which is a positive, as most insurance
companies rely on investment income to augment low underwriting profitability. The stronger operating
profitability, however, is mostly offset by lower-than-average marks for investment income (0.8) and balance
sheet surplus (2.53). In this case, "other adjustments" include reinsurance recoverables.
III. Insurance Financial Risk Score
The Insurance Financial Risk Score is a quantitative assessment of an insurer's credit health based on
three specific components:
1. Reserves Leverage: We evaluate reserves-to-capital and premium-to-capital ratios.
a. Reserves-to-capital gauges the exposure of the firm's capital to unexpected claims losses.
b. Premium-to-capital measures the insurer's exposure to underwriting mistakes relative to its
capital position.
2. Debt / Capital: This traditional measure captures an insurer's financial leverage.
3. Investment Portfolio Sensitivity Analysis: For this measure, we apply a one standard deviation loss
rate to each asset class in the company's investment portfolio. For traditional asset classes like
corporate debt and equities, the loss rates are provided by Ibbotson. For newer classes like ABS,
loss rates have been estimated from recent experience. We sum the losses from each asset class,
and express that total loss as a percentage of the insurer's capital base. Doing so allows us to
measure both the riskiness of the company's asset allocation, and the sensitivity of the balance
sheet to investment losses.
The loss rates applied to the various asset classes are listed below:
Investment Portfolio Assumed Loss Rates
U.S. Government Obligations
Municipal Bonds
Other Government Obligations
Corporate Debt
Residential Mortgage-Backed Securities (Agency)
Residential Mortgage-Backed Securities (Non-Agency)
Commercial Mortgage-Backed Securities
Non-Mortgage Asset-Backed Securities
General Asset-Backed Securities
Preferred Stock
Equity
Short-Term Investments

5.7%
6.8%
7.0%
8.3%
6.0%
11.5%
10.5%
7.3%
8.8%
14.4%
20.5%
5.7%

Analysts also have the ability to add additional, nonstandard asset classes to accommodate more unique
investment portfolios and special situations.

Morningstar Insurance Credit Rating Methodology

The Insurance Financial Risk Score is expressed as the following:

1
0.25 * (Reserves/Capital) 0.25 * (Premium/Capital)
3 * (Debt/Capital) 2.5 * (InvestmentSensitivtyScore)
We have used different multiples for each ratio, as each ratio operates on a different scale. For instance,
debt-to-capital, by definition, cannot exceed 1, but reserves-to-capital is typically much higher than 1 for
most insurers. The multipliers were chosen so that each measure contributes roughly equally to the overall
score, on average. We set the range of scores between 0 (best) and 1 (worst), such that each underlying
pillar's raw score (Business Risk, Debt Cushion, Financial Risk, and Distance to Default) is on a consistent
scale.
IV. Distance to Default Score
Step 1: Calculate annualized trailing 300 day equity total return volatility (EQVOL)
Step 2: Calculate current enterprise value / market cap ratio (EVMV)
Step 3: Transform EQVOL into a percentile [0, 1] by ranking it relative to all other stocks in the calculable
universe (EQVOLP). 1 represents high equity volatility, 0 represents low equity volatility.
Step 4: Transform EVMV into a percentile [0, 1] by ranking it relative to all other stocks in the calculable
universe (EVMVP). 1 represents high leverage companies, 0 represents low leverage companies.
Step 5: Calculate new raw DTD = 1-(EQVOLP + EVMVP + EQVOLP*EVMVP)/3
Step 6: Transform new raw DTD into a decile [1, 10] by ranking it relative to all calculable US-domiciled
stocks. 10 represents poor financial health while 1 represents strong financial health.
Recommended Credit Ratings
The weighted scores from each of the four components (45% for Insurance Business Risk, 25% for Insurance
Debt Cushion, 20% for Insurance Financial Risk, and 10% for Distance to Default) are added to achieve a final
score ranging from 0 (best) to 1 (worst). This score is multiplied by 100 and then mapped to the following
alpha distribution:

Morningstar Insurance Credit Rating Methodology

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Alpha Score
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
BCCC
CC
C

Description
Negligible Risk
Very Low Risk

Low Risk

Medium Risk

High Risk

Very High Risk

Minimum
0
1
6
11
16
21
26
31
36
41
46
51
56
61
66
71

Maximum
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
100

Currently Very High Risk

Currently Extreme Risk
Imminent Payment Default

Based on relevant firm-specific conditions (including an assessment of the timing to potential default), the
credit rating committee will make an assessment of whether an insurer should receive a final alpha score
below B-. All of our ratings are reviewed and approved by the credit rating committee.

Morningstar Insurance Credit Rating Methodology